A Fresh Look at What Caused the 1987 Crash
Gary Alexander on 10/21/2010 12:00:00 AM
This week marks the 23rd anniversary of the traumatic 1987 stock market crash. For the remainder of the 20th Century, this anniversary took on an ominous air: Could it happen again? After suffering the dot.com bust of 2000, the crash of 2002 and the financial crisis of 2008, memories of 1987 have faded, but it's still important to understand why crashes happen so that we can be armed in advance against the dangers of another crash. By the end of this exercise, you'll see why a crash is HIGHLY unlikely in the near future.
On October 19, 1987, the stock market fell 22.6% in one day - almost twice the decline of the second worst day on Wall Street. Like 1987, that was a Monday, October 28, 1929 - the now-forgotten Black day between Black Thursday (October 24) and Black Tuesday (October 29). The 1987 crash was certainly not the worst downturn in history (losing 35% in two months), but the severity of that one Monday put 1987 in the history books and planted an indelible image of panic in the mind of all who lived through it.
The first thing to remember about historic panics is that they generally follow parabolic increases during "manic" episodes of over-the-top greed. In the biggest crashes of the last century, like 1907, 1929, 1987 and 2000, the market was already high, but then it shot 50% higher in a year or so. A quarter century ago, the market was rising to all-time highs throughout 1985 and 1986. Then it took off in a hockey-stick rise in 1987. Therefore, the first clue to the cause of the 1987 crash is to find the cause of the manic boom.
On October 22, 1986, a year before the crash, President Reagan signed the Tax Reform Act of 1986 into law. The top rate was cut dramatically from 50% to 28%, giving us the closest thing to "flat taxes" we've seen in the last century. There were just two tax rates, 15% and 28%. Many of the classic tax deductions were jettisoned - including some business real estate deductions, leading to a crash in some real estate markets, but not in stocks. From a base of Dow 1805 on October 21, 1986, the Dow rose by over 50% in 10 months, to 2722. You could say that the bullish tax cut of 1986 created the boom that caused the crash.
What Caused the Crash? Politicians, not Computers
The summer of 1987 was a heady time on Wall Street, as 158 companies split their stock on the NYSE alone. However, interest rates were still near double-digits and Wall Street was engulfed in scandal: The Securities & Exchange Commission (SEC) was hauling in tax evaders and insider traders in a string of highly publicized cases. Traders were also getting arrested for using and peddling drugs. These were the "go-go" 1980s in their pre-crash manic peak. The Dow quietly peaked at 2722 on August 25, 1987.
However, the big political news came on August 11, when Alan Greenspan, a New York economist, was sworn in as chairman of the Federal Reserve Board, after being picked by President Reagan to succeed Paul Volcker. Shortly after the market peaked, Greenspan made a rookie mistake on September 9, firing a "pre-emptive strike" against inflation fears by raising the Discount Rate 50 basis points. The Dow fell 62 points on the news. Then, the final panic began to unfold on Wednesday, October 16, 1987, when a tax bill was introduced by the House Ways and Means Committee. The bill would have severely limited tax deductions for interest paid on debt used to finance takeover activity, which had been running rampant.
Another piece of news pushed the market down October 14 - record high trade deficit figures. The dollar had been too strong in the mid-1980s. The Prime Rate shot up on Thursday, October 15, and the bond market got hit hard. Bonds had fallen 13% in the previous six months. On Friday, Treasury bond rates climbed over 10% and contributed to Friday's record down day. On Saturday, October 17, 1987, U.S. Secretary of the Treasury James Baker III told the Germans to "either inflate your mark, or we'll devalue the dollar." On Sunday, October 18, Baker went on the Sunday morning talk shows, where he said that the U.S. "would not accept" the recent German interest rate increase. Later, an unnamed Treasury official said we would "drive the dollar down" if necessary. These were fighting words that panicked the market.
Some said that Baker's rash words, more than anything else, caused the Monday market crash: Jacques Delors, president of the European Commission, compared Baker's remarks to "a pyro-manic fireman. When you're living on the edge of the volcano, you don't light matches." Economist Pierre Rinfret also blamed Baker for the crash: "The Secretary of the Treasury started one of the worst panics in the history of the stock market." Noted trader Jimmy Rogers agreed: "The crash had nothing to do with program trading or arbitrage or investment insurance. Greenspan and Baker simply panicked and blew it."
The rest of the world crashed long before New York opened that Monday. The market day began in Asia, where Monday opened with a 33% drop in Singapore, a 17% loss in Tokyo and 11% down in Hong Kong - a market which closed for the rest of the week. Europe fared no better, with a 22% drop in London, 14% in Zurich and 13% in Frankfurt. Hearing this news over their breakfast coffee, New York traders were bearish from the start, as the market dropped 104 points in the first hour alone. By the middle of the day, the market held its losses to between 100 and 200 Dow points. But after 2:00 p.m., the market lost 100 points each half hour, reaching a 376 point drop by 3:30pm and a 508-point drop at the closing.
Tuesday morning, October 20, 1987 was actually the scariest time of the famous Crash of 1987. Despite Monday's record 508-point loss, there was no buying in the morning. The Dow fell 100 in early trading. Tuesday set a new volume record for the third straight day, at 608,120,000 shares. Much of the volume came from negative panic selling in the morning hours. But sometime in mid-morning, everyone looked at each other and thought "enough of this," and a buying panic began. The crash of 1987 was finally over.
October 21, 1987 brought us the largest one-day percentage gain since 1933, by a wide margin, and three of the four biggest daily gains of the late 20th Century came in one 10-day spurt in late October 1987: Tuesday, October 20: +102.27 (+5.9%) Wednesday, October 21: +186.84 (+10.1%) Thursday, October 29: +91.51 (+5.0%)
According to Ed Elfenbein at www.crossingwallstreet.com, the Dow is up 541% since the 1987 crash. If you add in dividends, it's up nearly twice as much, 1,050.3%. (Yes, he says, "dividends add that much!") With dividends, that's 11.2% per year annualized. With inflation at 2.83% a year since then, your real returns are 8.37% per year since 1987, despite the "lost decade" of near-zero market returns since 2000. The best news is that we are highly unlikely to see a major crash without seeing manic gains at record highs amidst a new wave of panic-buying and greed. We're obviously nowhere near those benchmarks.
In summary, blunders by two political appointees caused the 1987 crash. First, the rookie chairman of the Federal Reserve Board, Alan Greenspan, made it his first order of business to announce his presence by raising the Discount Rate in early September, 1987. That started the correction. Then, Secretary of the Treasury James Baker talked tough to the Germans about the dollar, causing the crash. Between Baker's currency wars, Greenspan's tight money, a new Congressional tax bill that punished capital gains, and more threats of protectionist legislation, the problem was too much, not too little, federal government.
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